Options

Spring 2007
Lecture Notes 4.6.1
Readings:Mayo 28
 Goals
• Definitions
• Options
– Call option
– Put option
• Option strategies
 Derivatives: Definition
• Derivative: Any security whose payoff
depends on any other security
 Goals
• Definitions
• Options
– Call option
– Put option
• Option strategies
 Options
• Two types
– Call: Option to buy
– Put: Option to sell
• Parts:
– Option price
– Strike price
– Expiration
 Call Option
• Option to purchase asset at the strike price
• Horizon:(two types)
– American: Anytime between now and the
expiration date
– European: On the expiration date only
• Strike price: Price at which the security
can be purchased
 Example:
Buying a call option on Amazon
• Amazon share price = $100
• Purchase American call option
– Option price = $5
– Strike price = $120
– Expiration = 2 months from now
• Case A: price goes to $150
– Exercise option
• Buy at $120, sell at $150
• Total = 150-120-5 = +$25
• Case B: price goes to $50
• Don’t exercise option
• Total = -5 (lose entire investment)
 Example:
Writing (selling) a call option on Amazon
• Amazon share price = $100
• Write American call option
– Option price = $5
– Strike price = $120
– Expiration = 2 months from now
• Case A: price goes to $150
– Purchaser exercises option
• Buy at $150, sell at $120
• Total = -150+120+5 = -25
• Case B: price goes to $50
• Purchaser doesn’t exercise option
• Total = +5
 Options and Insurance
• The writer is kind of selling insurance to the
buyer
• As long as the price doesn’t go up by too
much ($20) the writer gets to pocket the $5
• Like an insurance premium
• Danger: If price rises by large amount,
option writer can lose lots of money
How do you lose big money with
options?
• Write (sell) a naked call on Amazon.com (p =
100), strike price = 150
– Sell for $5
• You feel very happy (+5)
• Then Amazon goes to $250
• The other side of your option trade exercises the
option
• You must buy Amazon at $250, and sell it for
$150
 Option Terms
• In-the-money
• Stock price > call option strike price
• At-the-money
• Stock price = call option strike price
• Out-of-the-money
• Stock price < call option strike price
 Intrinsic Value
Value of option if used today

• Strike price = $100

Intrinsic Value

0 Stock Price
100 104 105
 Option Pricing
• Is it as easy as
• (Price – strike price) when strike < stock price
• 0 if strike is > stock price
• Why does this get more complicated?
• Have to consider today plus all days to the
expiration date
• Even though the price is in the zero value range
today (out-of-the-money, it might move into the
positive value range tomorrow
 General Properties of an option
price
• Option value will be higher:
– When the expiration date is farther in the future
– When the stock price moves around more
• (This is known as higher volatility)
 Option Pricing
• There are different formulas that try to take
account of all this stuff
• Black/Scholes is the most famous of these
• Techniques used
– Arbitrage
– Stochastic calculus
 Option Price (red) versus
Intrinsic Value (black)
Value of option if used today
• Strike price = $100

Intrinsic Value

0 Stock Price
100 104 105
 Goals
• Definitions
• Options
– Call option
– Put option
• Option strategies
• Real options
 Put Option
• Same as Call
– Price
– Strike price
– Expiration
• Difference: Option to Sell
 Example: Put Value
• Strike price = $100

Intrinsic Value
10
5

Stock Price
0
90 95 96 100
 Goals
• Definitions
• Futures
• Options
– Call option
– Put option
• Option strategies
 Options+Stocks
• Holding option alone is known as holding a
“naked option”
• Holding option with the stock is known as a
“covered option”
 Insuring gains by buying a put
option
• Purchasing a put option on stock you
already own sets a floor on what you can
sell
• Buy stock at 75, price rises to 100
• Lock in gains, buy put at strike = 100
• Gains will be at least 100-75
• Cost = price of the put option
 Example 1: Buy Stock + Put
• Strike price = $100
• How much would your portfolio (option +
stock) be worth for different prices?
Total Value

105

100 Stock Price

100 105
 Example 2: Option Straddle
• Purchase a put and call at the same strike
price
• Strategy makes money when stock price
moves a lot (volatility is high)
 Straddle Example
• Current stock price = 100
• Purchase at-the-money call (strike = 100)
for $2
• Purchase at-the-money put (strike = 100)
for $3
• What is the total value of your option
portfolio for different stock prices?
 Straddle Performance
• Lose money when no change in price
• Price goes up: Call makes money
• Price goes down: Put makes money
• Strategy makes money when price moves a
lot (depends on option prices)
 Straddle Contingency Graph
Plot of net $ gain as a function of stock price

• Strike price = $100

• Option prices: call = $2, put = $3

Net Gain
1
0
-5 Stock Price
94 95 100 105 106
 Writing Call Options
• Writing a naked call
• Writing a naked put
 Writing a Naked Call Option
(1 share, option price = $5, strike = 100)

+5

105 110
0
100 Stock
Price
-5
 Writing a Covered Call Option
(1 share, option price = $5, strike = 100, stock purchased at
100)

+5

90
0
95 100 Stock
Price
-5
 Other Combinations
• Many other combinations are possible
• As with futures, you can use options to
reduce risk or increase risk if you want
 Exotic Options
• More complicated functions of prices
• Often involve time path of prices
• Ordinary options do not care about path
• Example: Barrier option
– “deactivates” if price crosses a barrier any time
during a given period
 Other Applications
• Stock options
• Investment options
 Option Summary
• Can be used to either reduce, or increase
risk
• Have insurance like characteristics
• Derivatives as fire